ETFs Win Investors’ Favor

When clients ask Mike Nozzarella where they should put their money, the Newport Beach financial planner is increasingly likely to steer them toward exchange-traded funds -- arguably the hottest product in the mutual fund industry.

Created in 1993 by a Los Angeles native, exchange-traded funds hit critical mass last year, reaching $212 billion in assets through Nov. 30. That’s up from $151 billion in 2003, according to the Investment Company Institute.

Exchange-traded funds, or ETFs, are mutual funds that are traded like stocks. While most traditional mutual funds are priced once a day, ETF prices are updated throughout the trading day, allowing investors to react more quickly to market-moving trends.

There are also tax advantages. When investors redeem shares of traditional mutual funds, managers may have to sell holdings to raise cash to pay them off, triggering capital gains and, potentially, capital gains taxes for the fund’s remaining shareholders. ETF trading is done on exchanges, and the actions of shareholders have no tax consequences for other investors in the funds.

“ETFs are an easy, tax-efficient and low-cost way” to diversify a portfolio, said Nozzarella, managing director at Tarbox Equity.Assets in ETFs are still a pittance next to the $7.9 trillion in traditional mutual funds, but they are considered the fastest-growing category of fund, analysts say.

Net cash inflows -- the value of all ETFs issued minus the value of shares redeemed by brokers -- soared to a record $54.4 billion last year, up 260% from the year before and eclipsing the previous mark of $42.5 billion reached in 2000, according to an estimate by TrimTabs Investment Research of Santa Rosa, Calif., which tracks fund industry trends.

ETFs were created by former American Stock Exchange executive Nathan Most, who died in December at age 90. His aim was to create a more flexible and economical way to trade index funds such as those tracking the blue-chip Standard & Poor’s 500 index.

Most’s first effort was the SPDR, which mimicked the S&P; 500 and was nicknamed “Spyder” for its ticker symbol, SPY.

Since then, the number of ETFs available for trading has swelled to 149 by one count, tracking indexes ranging from the well-known Nasdaq 100 to the obscure New Zealand Mid Cap. The abundance of choices has given investors and advisors the ability to build broadly diversified portfolios using only ETFs -- a key reason for the explosion in the funds’ popularity.

What’s more, marketing by ETF issuers has heightened awareness among people looking for investment alternatives. Returns of actively managed mutual funds have disappointed some investors, while scandals have tarnished the traditional fund industry’s image. In a climate of modest gains, investors are focusing more on expenses -- where ETFs outshine even most index mutual funds -- and tax advantages.

At San Francisco-based Barclays Global Investors, whose iShares lineup of 97 ETFs has accounted for much of the sector’s growth, Managing Director J. Parsons said 60% of the inflow last year came from advisors such as brokers and planners or straight from self-directed investors. That marked a change from previous years, when institutions like pension funds and endowments accounted for most of the growth.

“Three years ago, a lot of people didn’t know what ETFs were,” said Paul Mazzilli, an ETF analyst at brokerage Morgan Stanley in New York. “Now most people, or at least their advisors, have heard of them.”

Barclays distributed no capital gains in 2004 for the third straight year.

Analysts say a consumer marketing push from firms such as Barclays, its Boston-based rival State Street Global Advisors and mutual fund giant Vanguard Group of Valley Forge, Pa., which rolled out 18 new “Viper” ETFs last year to expand its lineup to 20, has paid off with the public.

Often, the marketing is done through intermediaries who then relay the ETF message to their clients. Last year, Barclays held marketing “road shows” in eight cities, offering ETF education to 2,000 investment advisors at daylong conferences, Parsons said.

Brokerages including A.G. Edwards & Sons Inc. and TD Waterhouse Investor Services Inc. now publish model portfolios using ETFs, either by themselves or mixed with stocks and traditional funds, for their advisors and clients to use.

A big selling point for ETFs is their low expenses, which save shareholders money and boost returns. Because of higher expenses, the majority of actively managed mutual funds have lagged index funds over long periods. ETFs, in essence, are index funds that trade like stocks.

ETFs carry low expense ratios in part because issuers, which deal with institutions when creating new shares, don’t need to set up and staff costly retail distribution operations to serve the public directly. State Street’s Spyders, for example, cost investors 0.10% of assets per year -- cheap even when measured against most U.S. stock index mutual funds, which average 0.76%.

The equity market’s modest performance since the banner years of the late 1990s, has highlighted the importance of taxes and expenses.

“In a low-return environment, every little bit makes a big difference,” Mazzilli said.

Meanwhile, the old-line mutual fund industry has been coping with one scandal after another since September 2003, when New York Atty. Gen. Eliot Spitzer alleged that four fund companies allowed favored investors to make improper trades. Mazzilli said ETF inflows “started to jump” shortly after Spitzer’s bombshell.

Of course, ETFs have their drawbacks.

Although the funds have low expenses, brokerage commissions can wipe out the advantage for smaller investors.

Those who put $50 or $100 to work each month using a “dollar-cost averaging” strategy may find ETFs too costly even if they are using online discount brokers, Mazzilli said. Unlike “no-load” mutual funds, which investors can buy directly from fund companies at no extra cost, ETFs are typically bought and sold through brokers -- with each transaction generating a commission.

In addition, as index products, ETFs closely track their benchmarks, but by definition won’t ever beat them. Nozzarella said he rounds out ETF portfolios with actively managed funds from Tarbox Equity’s “select” list, such as JP Morgan Mid Cap Value and Artisan Mid Cap, to try to jazz up performance. Particularly in the fixed-income arena, Nozzarella said, savvy managers at firms such as Metropolitan West Asset Management and Pacific Investment Management Co. “can squeak out extra returns.”

ETFs can be highly volatile, especially those linked to certain foreign stock indexes, said ETF analyst Mariana Bush of Wachovia Securities. Taiwan’s main index, for example, is heavily weighted in semiconductor companies, while Mexico’s has a telecom tilt; when those sectors slump, look out below.

She said investors seeking foreign market exposure could opt for closed-end funds -- an alternative to both ETFs and standard mutual funds -- to exploit occasional pricing discrepancies. While ETFs always stick closely to the value of the underlying securities, closed-end funds are structured differently and can trade at a sharp discount or premium to their holdings, depending on whether their sector is in or out of favor.

With the ETF business riding high, look for plenty of new product launches this year.

Barclays, which last summer launched nine ETFs tied to the “style boxes” that Morningstar Inc. uses to categorize stocks and mutual funds, plans to roll out its first “socially responsible” ETF, a product tracking the KLD Select Social index of non-tobacco companies, as well as its own version of a gold bullion ETF.

“I don’t think even [Most] conceived of where this industry would go,” Parsons said.

In Portland, Ore., a firm called Invest n Retire hopes to bring ETFs to a wider audience in the 401(k) marketplace, where high fees have drawn regulatory scrutiny. Since launching its service in January 2004, Invest n Retire has signed up a dozen smaller-company 401(k) plans, said Chief Executive Darwin Abrahamson.

Abrahamson said his ETF menus could cut a 401(k) plan’s total costs to 0.8% to 1% of assets per year, roughly half the expense of some plans.

“That adds up big-time,” he said.

On Thursday, Banneker Capital Management Corp., a minority-owned investment firm in Owings Mills, Md., and plan administrator BenefitStreet Inc. announced plans for an all-ETF 401(k) platform of their own.

“Our partners have been asking for ETFs even before the mutual fund scandal hit in late 2003,” said Ken Weida, senior vice president of BenefitStreet in San Ramon, Calif.

Actively managed ETFs, as opposed to the index variety, could herald a new era of growth for the industry -- if they get past the planning stage.

Industry executives have talked about offering actively run ETFs for years, but the Securities and Exchange Commission would need to approve the idea before it could hit the market, Parsons said.

That OK could come late this year, he said, but a major hurdle remains.

Ironically, the transparency that attracts some investors to ETFs is a drawback when it comes to active management -- after all, competitive portfolio managers “don’t want their points of view out in the open on a daily basis,” as Parsons put it.

“We still haven’t figured that one out,” he said.